Author of "Lecturing Birds On Flying: Can Mathematical Theories Destroy The Markets?"

Why Nassim Taleb is the True Predictor of this Crisis

09/19/2009 05:12 am ETUpdated
May 25, 2011

The punditry and the world at large have been hard at work trying to find ex-ante predictors for the malaise that has engulfed our markets, our economies, and our societies. Desperate efforts to find those who "called it" have been relentlessly launched. We all seem to want to know who among us really saw the mayhem coming. It was unavoidable that such an agitated process would deliver a sizable dose of less-than-reliable prophets and less-than-robust explanations.

The breathless quest for prospective explainers, the unquenchable thirst for totemic ex-ante seers has resulted in the crowning of individuals who, notwithstanding their many qualities, did not get it exactly right before the troubles initiated. Yes, many of them did warn about the unsustainability of the housing bubble, and the insalubrious practices taking place in the sub-prime mortgage business, and (much less often) about the toxic nature of certain newfangled securities. But only one person among the appointed oracles truly pointed fingers at the true prospective culprit behind the current devastation. And he did so not in 2005 or 2006, but as far back (at least) as 1997.

This is what Nassim Taleb said more than a decade ago that qualifies him, in my eyes, as the true and only visionary:

I believe that Value at Risk is the alibi bankers will give shareholders and the bailing-out taxpayer to show documented due diligence, and will express that their blow-up came from truly unforeseeable circumstances and events with low probability, not from taking large risks they did not understand. ... I maintain that the due diligence VaR tool encouraged untrained people to take misdirected risk with shareholders' and ultimately the taxpayers', money.

In the midst of the credit nightmare, such pearls could not appear any more prescient. For VaR, the mathematical model used as risk radar by banks and chosen by regulators as the tool that sets capital charges for trading activities (what essentially dictates the amount of leverage that banks can engage in), did ultimately cause the crisis and the Taleb-predicted bail-out, precisely by providing reckless bankers with a seemingly scientific alibi to monstrously leverage their balance sheets with the most toxic and illiquid of financial wares. By being unrealistically low, VaR allowed banks to cheaply devour as much toxic stuff as they wanted. Since those gigantic toxic positions are what truly sank Wall Street, and since the sinkage of the latter is what truly unleashed what is known as the credit crisis, it follows that without VaR the pain would have been much more diluted.

This crisis was not really a "housing crisis," but a "trading crisis." Mortgage defaults on their own would have never created this kind of tremors. The melting into oblivion of complex securities based on those mortgages is what did unleash hell. VaR unseemly allowed banks to afford the complexity feast, and that's why I declare it guilty numero uno. Only Taleb saw this coming, more than ten years ago. If only we had listened to him more attentively.